Transcript

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The Functions of Money Medium of Exchange *usable for buying and selling goods and services *allows society to escape the complications of bartering *allows society to gain the advantages of geographic and human specialization

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The Functions of Money Unit of account *acts a yardstick for measuring relative worth of a wide variety of goods, services, and resources *enables buyers and sellers to easily compare the prices of various goods, services, and resources

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The Functions of Money Store of Value *enables people to transfer purchasing power from the present to the future *we have to store some of our income to buy things later *when inflation is low or nonexistent, holding money is relatively risk-free for preserving your wealth

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What “backs” the money supply? The money supply in the US essentially is “backed” (guaranteed) by the government’s ability to keep the value of money relatively stable. Nothing more!

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Money as Debt Paper money and checkable deposits are debts, or promises to pay They have no intrinsic value—they are just pieces of paper or bookkeeping entries The gov’t will not redeem your paper money for anything tangible, like gold ***Gold standard—not reliable because harder to control the money supply

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Value of MoneyWhy are currency and checkable deposits money, and Monopoly money is not? Acceptability—ppl accept them as money Legal tender—must be accepted in payment of a debt **fiat money—money because the government has declared it so, not because it can be redeemed for precious metal

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Value of Money (con’t.) Relative Scarcity—value of money depends on supply and demand **supply of money will determine the value or “purchasing power” of the monetary unit

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Money and Prices The purchasing power of the dollar varies inversely with the price level When CPI goes up, the value of the dollar goes down, and vice versa D = 1/P(D=value of dollar, P=price level)

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Money and Prices When the gov’t issues so much money that the value of the money is undermined Runaway inflation can depreciate the value of the money Rapid declines in the value of money may cause it to cease being used as a medium of exchange

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The Demand for Money Transactions Demand (Dt)—the demand for money for uses such as purchasing goods and services or paying for factors of production * Main determinant of money demanded for transactions is the level of nominal GDP

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The Demand for Money Asset demand (Da)—Derived from money’s function as a store of value so people may hold their financial assets in many forms, including corporate stocks, private or government bonds, or money * Varies inversely with the rate of interest— when interest rate is low, the public will choose to hold a large amount of money assets *When interest rate is high, amount of assets held as money will be small

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The Demand for Money Total Money Demanded (Dm)—Found by adding Da and Dt—total amount of money public wants to hold at each possible interest rate * will change with increases/decreases in nominal GDP

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The Money Market Money Market—Combining the supply and demand for money to determine the equilibrium rate of interest Supply of Money (Sm) is a vertical line because the economy has some particular stock of money (such as M1) provided by the monetary and financial institutions

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Federal Reserve System or the “Fed” Federal Reserve System—the US’s monetary authorities made up of the Federal Reserve Banks and overlooked by the Board of Governors

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Historical Background Early in 20th century, Congress decided that centralization and public control were essential for an effective banking system Decentralization has fostered inconvenience and confusion of numerous bank notes being used as currency

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Historical Background It had also resulted in episodes of monetary mismanagement when the MS was inappropriate to the needs of the economy (too much $ led to rapid inflation, too little $ stunted the economy’s growth) This led to the Federal Reserve Act of 1913

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Board of Governors Central authorities of the US money and banking system The US president, with the confirmation of the Senate, appoints the seven Board members Terms are 14 years and are staggered so that one member is replaced every 2 years

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Board of Governors New members are also appointed when resignations occur The president selects the chairperson and vice-chairperson of the Board from among the members

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Assistance and Advice Several entities assist the Board of Governors in determining banking and monetary policy The Federal Open Market Committee (FOMC) is made up the 7 members of the Board plus five of the presidents of Federal Reserve Banks

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Assistance and Advice The FOMC sets the Fed’s monetary policy and directs the purchase and sale of government securities (bills, notes, and bonds) Three Advisory Councils made up of private citizens meet periodically with the Board of Governors to voice their views on banking and monetary policy

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Assistance and Advice The Federal Advisory Council is composed of 12 commercial bankers, one selected annually by each of the 12 Federal Reserve Banks The Thrift Institutions Advisory Council consists of representatives from savings and loan associations, savings banks, and credit unions

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Assistance and Advice The 30-member Consumer Advisory Council includes representatives of consumers of financial services and academic and legal specialists in consumer matters

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The 12 Federal Reserve Banks The 12 Federal Reserve Banks collective serve as the nation’s “central bank”; they blend private ownership and public control and mainly are so-called bankers’ banks The 12 Federal Reserve Banks serves different districts and all implement the basic policy of the Board of Gov.

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Quasi-Public Banks 12 Federal Reserve Banks are quasi-public Each Fed. Res. Bank is owned by the private commercial banks in its district (commercial banks are required to purchase shares of stock in the Fed Res Bank in their district)

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Quasi-Public Banks But a gov’t body (the Board of Gov) sets the basic policies that the Fed. Res. Banks pursue Despite private ownership, the Banks are in practice public institutions They are not motivated by profit

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Bankers’ Banks Fed Res Banks perform the same functions for banks and thrifts as those institutions perform for the public * Accept deposits and make loans to banks and thrifts *Issue currency

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Fed Functions and the MS Issuing currency—issue Fed. Res. Notes, the paper currency used in the US Setting reserve requirements and holding reserves—sets the amount/fraction of checking balances that banks must maintain as currency reserves; accept and portion of the reserves not held as vault cash

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Fed Functions and the MS Lending money to banks and thrifts—will lend money to banks and thrifts and charge them an interest rate called the discount rate Providing for check collection—Adjusts reserves to compensate for checks written

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Fed Functions and the MS Acting as a fiscal agent—provides financial services for the Federal government Supervising banks—makes periodic examinations to assess bank profitability and accordance to Fed regulations

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Fed Functions and the MS Controlling the money supply—Fed regulates supply of money, and in turn enables it to influence interest rates; makes amount of money available that is consistent with high and rising levels of output and employment and a relatively constant price level

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Federal Reserve Independence Congress purposely established the Fed as an independent agency of government Political pressures on Congress may result in inflationary fiscal policy If executive branch also controlled the nation’s monetary policy, there could be pressure to keep interest rates low even when high interest rates are needed

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Federal Reserve Independence Studies show that countries that have independent central banks like the Fed have lower rates of inflation, on average, than countries that have little or no central bank intelligence

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Fed Functions Issuing currency Setting reserve requirements—the percentage of each deposit that a bank must keep on hand in their vault Lending money to banks when they don’t have enough reserves in their vaults Check collection

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Interest Rates Interest is the price of money—how much it costs to borrow moneyPrice of Money Supply of Money—vertical because it(interest rate) Is a constant amount (how much is in Circulation) Interest rate Demand of Money—how much People desire/need/want to take Out in a loan Qm Quantity of Money

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Monetary Policy The Fed controls the money supply, and therefore the interest rate As they change the amount of money in circulation, the price of money changes (or the interest rate)

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Tools of Monetary Policy Open Market Operations—the buying of bonds from, and the selling of bonds to, the general public and commercial banks Fed’s most important instrument for influencing the money supply

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Tools of Monetary Policy The reserve requirement or reserve ratio—the amount of each deposit the bank must keep in their vaults Limits the amount of each deposit the bank may loan out to another customer When the bank can loan out a lot, they can increase the money supply When the banks can not loan out much, they are decreasing the money supply

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Reserve Ratio You deposit $1,000 in your bank account. The reserve ratio is 25%--that means they must keep 25% of the deposit in the vault They set $250 in the vault, but use the other $750 to loan out to another customer That $750 plus the interest they charge the customer is increasing the money supply, thereby decreasing interest rates

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Reserve Ratio Say the same $1,000 is deposited in a bank, but this time the reserve requirement is lowered to 20% Now they must keep $200 in their vaults and loan out $800 This is an bigger increase in the money supply because they can loan out more

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Tools of Monetary Policy The discount rate—the interest rate the Fed charges on loans to other banks Banks may nightly take out loans from the Fed if they have loaned out more than they are allowed to (determined by the reserve ratio) The banks are still charged interest by the Fed, called the Discount Rate

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The Discount Rate When the discount rate is low, banks are more willing to loan out their reserves because they can just take out a loan from the Fed later to cover that loan. This increases the money supply because will be looser with their money and their loans.

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The Discount Rate When discount rate is high, banks don’t want to take out a loan from the Fed. They will be less likely to loan out their reserves, thereby decreasing the money supply because of their unwillingness to give out as many loans.

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How does this affect the economy? By increasing and decreasing the money supply, the Fed is increasing or decreasing the interest rates. When interest rates are high, people are less willing to take out loans. When interest rates are low, people are more willing to take out loans.

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How does this affect the economy? Remember the determinants of GDP (and AD)? GDP (or AD) = C + I + G + X The I stands for Investment—money people take out of a bank in the form of loans to buy/invest in something. If we increase or decrease I, everything else equal, we are increasing and decreasing GDP/AD

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How does this affect the economy?Interest rates decrease—more people take out loans—AD increases becauseI has increased—this increases the price level (inflation) and GDP (production) Price Level ASPL1 or new inf.PL or inflation AD 1 AD GDP New GDP GDP

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How does this affect the economy?Interest rates increase—people take out less loans, thereby decreasing I—asI decreases, so does AD—that decreases inflation and GDP Price Level AS PL or inflationPL1 or new inf. AD AD 1 New GDP GDP GDP

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Strengths of Monetary Policy Speed and Flexibility Isolation from political pressure Past success in the 1980s and 1990s  Inflation from 13.5% in 1980 to 3.2% in 1983  Recovery from recession of 1990-1991

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Problems with monetary policy Less control with more electronic transactions Changes in velocity of money (the number of times per year the average dollar is spent on goods and services) Less reliable in pushing the economy from a recession (cannot force people to take out loans)—think Japan 1990s